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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Are Energy Junk Bonds Worth The Risk?

Drilling Rig Workers

The energy economics picture is starting to diverge across the sector. Some of the more efficient oil producers, especially onshore frackers, are slightly profitable at current oil prices. By contrast, the less efficient onshore producers and most of the offshore producers are still breaking even at best and in most cases losing money. This divergence is upending the energy industry in new ways. A recent report suggested that offshore production is actually less economically efficient than onshore fracking for instance.

Against this backdrop, investors have to make a choice – buy quality companies at more expensive prices, or lower quality assets at deeply discounted prices. Nowhere is that conundrum more acute than in the fixed income space. In some extreme cases, distressed E&Ps are offering enormous yields. For instance, offshore giant, Transocean had to up yields on a new bond issue and reduce the size of their bond offering. Transocean’s situation could be much worse though - Ultra oil now yields 1,400 percent on 2024 bonds.

Investors looking at this space need to go into the investment arena with their eyes wide open. Historically junk bonds have been a fairly good investment – yielding about 8 percent after defaults since 1980. This is only a couple of points less than the 11 percent average return on equities over that time.  Still the historical record is quite mixed on that point.

The key for investors looking at this space then is diversification and a long-term investment horizon. High yield bonds could have a good or bad return in any given year, but over time they should prove to be a good investment. Investors need to look very carefully at any individual companies they are considering and the assets that are backing that particular credit.

In the energy space, firms with attractive acreage – even undeveloped or partially developed acreage – are likely to be a better bet than offshore firms, for instance. Despite being the first segment of the energy sector to go into the tank, offshore is likely to be one of the last to exit. Many offshore firms have been significantly damaged by necessary hot and cold stacking of rigs. A return to former levels of profitability is unlikely in the short-term then, and rigs that were once productive assets can quickly turn to costly liabilities when stacking is required. Onshore companies are perhaps a little bit safer than offshore, but again, assessing individual credits is key. Related: Did Oil Kill The Dinosaurs?

Despite the pessimism in the space, investors could still find some good opportunities. S&P is forecasting only a modest uptick in near-term default rates as the chart below shows. For investors who can sort through and find high quality credit opportunities trading at junk prices, the current environment does present a major opportunity. Again, the only investors who should be looking at individual investments are those with the capacity and ability to do the appropriate due diligence and make reasonable decisions on credit quality and asset recovery rate forecasts in a default. For the rest of the investors out there, quality should trump yield and the energy junk bond space is better left alone at present.

(Click to enlarge)

By Michael McDonald of Oilprice.com

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